Euro countries risk sliding into depression

Another rescue package seems inevitable but the conditions demanded by Germany would be harsh

None of Euroland's key actors seems willing to admit that the present strategy is untenable.

They hope to paper over the cracks until the German elections in September, as if that is going to make any difference.

A leaked report from the European Commission confirms that Greece will miss its austerity targets yet again by a wide margin. It alleges that Greece lacks the "willingness and capacity" to collect taxes.

In fact, Athens is missing targets because the economy is still in freefall and that is because of austerity overkill. The Greek think-tank IOBE expects GDP to fall 5 per cent this year. It has told journalists privately that the final figure may be -7 per cent. The Greek stabilisation is a mirage.

Italy's slow crisis is again flaring up. Its debt trajectory has punched through the danger line over the past two years. The country's €2.1 trillion ($3.5 trillion) debt - 129 per cent of GDP - may already be beyond the point of no return for a country without its own currency.

Standard & Poor's did not say this outright when it downgraded the country to near-junk BBB on Tuesday. But if you read between the lines, it is close to saying the game is up for Italy.

Its point is that if "nominal GDP" remains near zero, Rome will have to run a primary surplus of 5 per cent of GDP each year to stabilise the debt ratio. "Risks to achieving such an outturn appear to be increasing," it said.

Indeed. The International Monetary Fund has just slashed its growth forecast for Italy this year to -1.8 per cent. The accumulated fall in Italian output since 2007 will reach 10 per cent. This is a depression. Yet how is the country supposed to get out of this trap with its currency overvalued by 20 per cent to 30 per cent within the EMU?

Spain's crisis has a new twist. The ruling Partido Popular is caught in a slush-fund scandal of such gravity that it cannot plausibly brazen out the allegations any longer, let alone rally the nation behind another year of scorched-earth cuts. El Mundo says a "pre-revolutionary" mood is taking hold.

A magistrate has obtained the original "smoking gun" alleging that Premier Mariano Rajoy accepted illegal payments as a minister. The left is calling for his head but so are members of the Consejo General del Poder Judicial, the justice watchdog.

"Citizens cannot tolerate a situation where the Prime Minister has received undeclared payments," said Jose Manuel Gomez, a Consejo member. Much of the ruling party appears tainted by a network of covert funding. If proved, said Gomez, it poses a "very grave" threat to Spanish democracy.

Portugal is slipping away. Professor Joao Ferreira do Amaral's book, Why We Should Leave The Euro, has been a bestseller for months. He accuses Brussels of serving as an enforcer for Germany and the creditor powers.

Like Greece before it, Portugal is chasing its tail in a downward spiral. Economic contraction of 3 per cent a year is eroding the tax base, causing Lisbon to miss deficit targets. A new working paper by the Bank of Portugal explains why it has gone wrong.

The fiscal multiplier is "twice as large as normal", or 2.0, in small open economies during crisis times.

What is new is that Vitor Gaspar, the high priest of Portugal's shock therapy, has thrown in the towel. He blames the fainthearted for refusing to slash with greater vigour. Needless to say, he still refuses to accept that a strategy of wage cuts and deflation in a country with total debt of 370 per cent of GDP was always likely to fail.

If Portugal does pull off an "internal devaluation" within the EMU it will shrink the economic base. Yet the debt burden remains. This is the dreaded denominator effect. Public debt has jumped from 93 per cent to 123 per cent since 2010 alone.

The Gaspar exit has closed a chapter. The junior coalition partners are demanding a change of course. I write before knowing whether President Anibal Cavaco Silva will call a snap election, opening the way for a left-leaning anti-austerity government.

The Portuguese press is already reporting that the European Commission is working secretly on a second bail-out, an admission that the wheels are coming off the original €78 billion EU-IMF troika rescue.

This is a political minefield. Any fresh rescue would require a vote in the German Bundestag, certain to demand ferocious conditions if this occurs before the elections.

Europe's leaders have given a solemn pledge that they will never repeat the error made in Greece of forcing an EMU state into default, with haircuts for banks and pension funds. If Portugal needs debt relief, these leaders will face an ugly choice.

Do they violate this pledge, and shatter market confidence? Or do they admit for the first time that taxpayers will have to foot the bill for holding EMU together? All rescue packages have been loans so far. German, Dutch, Finnish and other creditor Parliaments have never yet had to crystallise a single euro in losses.

All this is happening just as tapering talk by the Fed sends shockwaves through credit markets, pushing up borrowing costs by 70 basis points across Europe. Spanish 10-year yields are back to 4.8 per cent. These are higher than they look, since Spain is already in deflation once tax distortions are stripped out. Real interest rates are soaring.

By doing nothing to offset this, the ECB is allowing "passive tightening" to occur. Mario Draghi's attempt to talk down yields with his new policy of forward guidance is spitting in the wind. The ECB needs to turn on the monetary spigot full blast - like the Bank of Japan - to head off a slide into deflation trap and enveloping disaster by next year. This is not going to happen.

Markets have reacted insouciantly so far to these gestating crises across Club Med.

They remain entranced by the "Draghi Put", the ECB's slowly fraying pledge to backstop Italian and Spanish debt, forgetting that the ECB can only act under strict conditions, triggered first by a vote in the Bundestag.

These conditions can no longer be fulfilled. The politics have curdled everywhere. Sooner or later, this immense bluff must surely be called.